Performance-related Pay and Productivity: Evidence from Japan

Traditionally, Japanese firms are known for the use of a pay system which rewards their workers for long-term skill development through on-the-job training within the firm. Changing its traditional reward system to performance-related pay (PRP) which ties pay to shorter-term performance is one of the most often-discussed topics concerning Japan's human resource management (HRM) policies/practices in the last two decades or so. Proponents of the change urge Japanese firms to abandon their traditional reward system and adopt PRP in order to boost productivity and maintain/regain global competitiveness. Opponents question their underlying premise that PRP boosts enterprise productivity. The controversy has not been resolved in large part due to the lack of rigorous evidence on the productivity effect of PRP in Japan. In this paper, we provide such evidence by estimating production functions augmented by PRP, using unique firm-level panel data. Unlike prior studies that use cross-sectional data, we are able to estimate fixed effect models and hence identify the productivity effect of PRP separately from that of time-invariant unobserved firm characteristics such as corporate culture, tradition, and inherent managerial quality. Overall, we find no significant productivity effect of PRP, which tends to favor skeptics. However, we also find evidence that PRP does yield significant productivity gains for firms that no longer subscribe to the traditional "lifetime employment" practice; and for firms that use employee involvement and tap into local knowledge of frontline workers. As such, our findings point to the importance of HRM complementarity. Changing the traditional pay system to PRP without changing the rest of the traditional Japanese HRM system such as "lifetime employment" is ineffective. Likewise, it is futile to offer workers incentive (PRP) while neglecting to provide them with an opportunity to share their productivity-enhancing local knowledge (employee involvement).